Are government bonds really risk-free?

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The most obvious reason for investing in government bonds is the low risk associated with it. It’s largely viewed as a risk-free mode of investment. However, is it really the gospel truth? While bonds issued by the central or federal government of a country may be free of default risks, there are still other kinds of risks linked to such investments that very much exist. Interest rate risk and inflation risks are a few of these that impacts any bondholder.

“Govt bonds are considered risk-free because there is a sovereign guarantee, but default risk is only one of many risks associated with investments in debt securities. Other risks like liquidity, market risk or interest rate risk still exist,” said Ajinkya Kulkarni, co-founder at Wint Wealth.

Unlike other risks, interest rate risk has a direct impact on a bondholder in two ways. Firstly, all bonds, except zero-coupon bonds, pay periodic coupons that need to be reinvested to earn a compounded rate of return. Hence, there is a reinvestment risk which implies the probability of interest rates being low when the coupon is paid out.

“The risk of reinvestment is that cash flows received from an investment in the bond will earn less when used in new investment. Suppose, if the bond market rate is 5% and you buy Rs 1,00,000 worth of bonds for 5 years expecting Rs 5000 per year. Now, in those five years, the rate of the bond falls to 2%,” Kulkarni explained.

But you will receive all scheduled 5% interest payments and the entire Rs 1,00,000 principal at maturity. The problem, however, is that if the investor buys another bond, they’ll no longer receive 5% interest payments.

The second facet of interest rate risk is market risk or price risk. It means the interest rates can sometimes be high when the bond is sold in the secondary market. If the prevailing yield is higher, the price received by the bondholder will be significantly lower.

“So, if you invested in a bond when the interest rate was at 5% and the yield suddenly goes up to 6% for the upcoming bonds. You’ll have to sell the bond at a discount as there is already a bond in the market with a 6% yield,” Kulkarni stated.

Other significant risks include the infamous inflation risk. If inflation rate is high, the purchasing power of the cash flows received from the bond will decline.

Although you might be able to liquidate your bonds, there are still some risks there. If you cannot cash out to the preferred time when the bond has the highest cashflows, then you’ll probably make a loss. So, there is always liquidity risk.